RetireMentors

Financial Planning

Why young investors should embrace bear markets

Kenneth Roberts is a private wealth manager at
Universal Value Advisors and
has been in the securities business for over 20 years and has worked as an
investment advisor, branch manager, professional trader and portfolio manager.
He specializes in managing income and growth portfolios and has expertise using
option strategies to produce income and control risk. Ken is also the author of
“The
Tactical Option Investor” and the host of
Ken’s Bulls and Bears
Report heard throughout Northern Nevada on the radio. You can follow Ken on
Twitter @TacticalOptions.

Understanding the time value of money is critical for all investors, particularly young employees in the early phase of their careers, just starting their retirement plans. It's very important to understand how money compounds over time at different rates of return.

Younger people in the accumulation phase of their retirement plan typically make monthly contributions to an employer sponsored qualified retirement plan such as a 401(k). Investing on a regular basis is known as dollar cost averaging. That means that you are investing a set amount consistently according a schedule. For example, say you contribute $100 a month on the first of each month and maintain that discipline for a long period. Just $100 monthly can add up to a tidy sum given a long time frame like 30 or 40 years. A $1,200 annual contribution earning a consistent rate of 8% will grow to over $300,000 in 40 years.

If you get a fixed rate of return on an investment a lump sum will always outperform a dollar cost averaging approach. Looking at the $100 a month example above for a 40-year period, if you had the entire $48,000 to invest at the beginning of the period, held it the same amount of time (40 years) and got the same rate of return (8%) it would grow by more than three times as much to over $1 million dollars.

The stock market, of course, doesn't pay a fixed rate of return. The returns from stocks can be highly variable and there have been periods in history where the dollar-cost averaging approach outperformed a lump-sum investment over the same time period. Dollar cost averaging can work well throughout bear markets. Analyzing some past bear market cycles with an averaging approach confirms that young investors should be patient and stick to their discipline during down market cycles.

Let's look at some real life examples. If you had invested a lump sum of $24,000 into the SPDR S&P 500
SPY, -0.20%
the exchange-traded fund that represents the Standard & Poor’s 500 Index, on July 1, 1994 it would have been worth $147,932.46 on July 1, 2014. Had you invested the same amount of dollars at a rate of $100 a month over the same 20-year period, that would have grown to $56,496.21, which illustrates that a lump sum normally produces superior results.

Evaluating the last 14 years instead of the last 20 produces a very different result. The lump sum of $16,800 invested into SPY on July1, 2000 would have grown to $30,070.06 by July 1, 2014. Dollar-cost averaging the same amount of money ($100 a month for 168 months) would have resulted in a valuation of $31,962.68 by July 1, 2014. The last seven years were also a time frame where the dollar cost averaging approach was better. $8,400 invested on July 1, 2007 would have compounded to $13,175.84 by July 1, 2014, while a monthly dollar cost averaging approach with the same amount would have grown to $14,216.56.

Bear markets can be frustrating, but young people with a long-term time frame need to be patient and realize that over time, going through some bear market cycles can work to their advantage. Market tops can only be recognized with any clarity in hindsight, but investors with a lump sum to invest may want to consider where the market level is before committing a lump sum. Both of the bear market cycles mentioned above saw the lump sum amount drop by over 40% and it took many years just to get back to even. The chart below should clarify the findings.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.